Category: Growth Models

A discussion of the African Development Bank’s report utilizing the Solow Model and examining welfare effects.

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Introduction

GDP per capita in Sub-Saharan Africa is the lowest in the world at $1,594 in 2015 (World Bank 2015). Rates of extreme poverty (living on less than $1.90 per person per day) are the highest in the world at 40 percent in 2015 (World Bank 2015). While other countries such as China, India, Vietnam and Cambodia have experienced rapid growth over the last quarter century, bringing millions of their citizens out of poverty and industrializing their economies, most African countries have economies based largely on agriculture and commodities, sectors that are susceptible to shifts in exogenous factors such as international prices and weather. As the continent seeks to alleviate the mass poverty, build its vital infrastructure, and join the ranks of other high-growth countries, the African Development Bank (AfDB) was instituted to “spur sustainable economic development and social progress in its regional member countries (RMCs), thus contributing to poverty reduction” (AfDB).

The AfDB recently held its 52nd annual meeting, at which it released its annual assessment on the economic outlook for Africa. A newspaper article in the Ugandan Daily Monitor, “Africa’s Economic Growth Bright – AfDB,” reported on the document and summarized its projections. The report predicted growth of 3.4 percent in 2017, up from 2.2 percent in 2016. The lower growth in 2016 was “due to low commodity prices, weak global recovery and adverse weather conditions” and the expected rebound in 2017 is “on the assumption that as commodity prices recover, the world economy will be strengthened and domestic macroeconomic reforms are entrenched” (Daily Monitor, June 2017).

Are the Report’s Assumptions Realistic?

The growth rates predicted in the AfDB’s report are higher than growth rates in the United States. This is not surprising, as developing countries typically have higher growth rates than developed countries. While higher than projected growth rates in developed countries, the AfDB report’s rates are lower than those projected in China. China’s growth rate, although slowing somewhat (from 14 percent in 2012 to 7 percent in 2015), remains one of the highest in the world. That the projection in the AFDB report is between that of the United States’ and China seems reasonable.

Although the figure might be within a reasonable range, it is important to evaluate if the assumptions made about the drivers of this growth are reasonable. The projection is based “on the assumption that as commodity prices recover, the world economy will be strengthened and domestic macroeconomic reforms are entrenched.”

The assumption that commodity prices will go up is line with most analysts’ estimates. The World Bank’s Commodity Markets Outlook forecasts higher prices for industrial commodities such as energies and metal and stable prices or a small decrease in the prices of grains and some other agricultural products (World Bank, April 2017). As different African countries contain different natural resources and have varying economic dependence on commodity exports, they will be affected individually by price changes. But the overall impact of price changes is likely to be positive.

It is a strong assumption to say that the world economy will be strengthened next year. There is a great deal of uncertainty in international trade and financial markets being caused by international terrorism and the nationalistic movements in the Europe and the United States. Furthermore, the continued cooling of China’s economy will not only affect international growth, but also will significantly reduce demand for raw materials. This will have a severe impact on Africa, as many African countries’ economies are reliant on exports of raw materials.

Finally, the reinforcement of domestic macroeconomic reforms within Africa depends on African leaders’ willingness to fight corruption and make their markets better for doing business. The incentives align for these reforms to advance and Africa’s economy should continue to become more pro-growth. So, while some of the assumptions in the AfDB’s report are more realistic than others, it is safe to expect economic conditions that are favorable for growth in Africa.

Evaluating African Growth Using Economic Models

Economists use formalized models to derive predictions about future economic growth within one country and differences in growth patterns among countries. One such macroeconomic model is the Solow Model, named after Robert M. Solow, who won the Nobel Prize in Economics for the 1956 paper in which he introduced the model (Solow 1956). It is a neoclassical model in that total output is a function of capital and labor. The model expresses output in per worker terms such that per capita GDP only grows with capital accumulation, which in turn only increases by a higher saving rate or lower rate of depreciation of capital. The implication is that a higher saving rate increases per-capita GDP, but that the growth rate of per capita GDP would return to zero. Later revisions to the Solow model added in a term for human capital to explain sustained economic growth and differences in cross-country differences in per-capita GDP (Mankiw et al, 1992).

Unfortunately, the Solow Model is not particularly suitable for evaluating the drivers of growth that are projected in the AfDB report. Higher commodity prices are essentially lump-sum payments to commodity exporting countries. While this is going to make those countries better off, changes in the terms of trade do not have an impact on the Solow Model output function or growth rate function. Similarly, a strong recovery in the global economy does not directly factor into the Solow Model. However, these sources of growth will have an indirect effect on the Solow Model output function. A stronger global recovery will give multinational corporations additional capital to invest, higher commodity prices will direct that capital towards commodity-rich countries, and African domestic macroeconomic reforms will encourage these corporations that Africa is business-friendly. This increase in foreign direct investment raises the level of capital. Per the Solow Model, this will lead to a higher level of output and a higher level of growth in the short-term. These results are consistent with the AfDB’s report.

Welfare Implications

Assuming the projections within the AfDB’s report are accurate, how will this growth impact poverty, inequality and other measures of household well-being? Because the growth is mainly projected to be driven by changes in commodity prices, demand for the unskilled labor that produces these commodities will increase and the remote areas where these resources are located will gain greater access to domestic and international markets. These changes will reduce poverty and improve the standards of living among the rural poor in African countries. Nonetheless, the clear majority of the income that will arise from the increase in commodity prices will likely flow to wealthier portions of the population who provide the capital to produce these commodities. As such, the effect of the growth on measures of inequality such as the Gini Coefficient is unclear.

About

This blog is a project for Econ 416: Theory of Economic Development, at the University of Maryland. Posts are contributed by undergraduate students, and do not represent the views of the University of Maryland.